How To Calculate A Return On Investment

The Gotham Gal and I make
a fair number of non-tech angel investments. Things like media,
food products, restaurants, music, local businesses. In these
investments we are usually backing an entrepreneur we've gotten
to know who delivers products to the market that we use and love.
The Gotham Gal runs this part of our investment portfolio with
some involvement by me.

As I look over the business plans and projections that these
entrepreneurs share with us, one thing I constantly see is a lack
of sophistication in calculating the investor's return.

Here's the typical presentation I see:

The entrepreneur needs $400k to start the business, believes
he/she can return to the investors $100k per year, and therefore
will generate a 25% return on investment. That is correct if the
business lasts forever and produces $100k for the investors year
after year after year.

But many businesses, probably most businesses have a finite life.
A restaurant may have a few good years but then lose its
clientele and go out of business. A media product might do well
for a decade but then lose its way and fold.

And most businesses are unlikely to produce exactly $100k every
year to the investors. Some businesses will grow the profits year
after year. Others might see the profits decline as the business
matures and heads out of business.

So the proper way to calculate a return is using the "cash flow
method". Here's how you do it.

1) Get a spreadsheet, excel will do, although increasingly I
recommend google docs
spreadsheet because it's simpler to share with others.

2) Lay out along a single row a number of years. I would suggest
ten years to start.

3) In the first year show the total investment required as a
negative number (because the investors are sending their money to
you).

4) In the first through tenth years, show the returns to the
investors (after your share). This should be a positive number.

5) Then add those two rows together to get a "net cash flow"
number.

6) Sum up the totals of all ten years to get total money in,
total money back, and net profit.

7) Then calculate two numbers. The "multiple" is the total money
back divided by the total money in. And then using the "IRR"
function, calculate an annual return number.

It's worth looking for a minute at the theoretical example. The
investors put in $400k, get $100k back for four years in a row
(which gets them their money back), but then the business
declines and eventually goes out of business in its seventh year.
The annual rate of return on the $400k turns out to be 14% and
the total multiple is 1.3x.

That's not a bad outcome for a personal investment in a local
business you want to support. It sure beats the returns you'll
get on a money market fund. But it is not a 25% return and should
not be marketed as such.

I hope this helps. You don't need to get a finance MBA to be able
to do this kind of thing. It's actually not that hard once you do
it a few times.

Fred Wilson is a partner at Union Square Ventures. He writes
the influential A VC,
where this post was originally published.